A corporate structure is perhaps the most advantageous way tostart a business because the corporation exists as a separateentity. In general, a corporation has all the legal rights of anindividual, except for the right to vote and certain otherlimitations. Corporations are given the right to exist by the statethat issues their charter. If you incorporate in one state to takeadvantage of liberal corporate laws but do business in anotherstate, you’ll have to file for “qualification” in the state inwhich you wish to operate the business. There is usually a fee thatmust be paid to qualify to do business in a state.
You can incorporate your business by filing articles ofincorporation with the appropriate agency in your state. Usually,only one corporation can have any given name in each state. Afterincorporation, stock is issued to the company’s shareholders inexchange for the cash or other assets they transfer to it in returnfor that stock. Once a year, the shareholders elect a board ofdirectors, who meet to discuss and guide corporate affairs anywherefrom once a month to once a year.
Each year, the directors elect officers such as a president,secretary and treasurer to conduct the day-to-day affairs of thecorporate business. There may also be additional officers such asvice presidents, if the directors so decide. Along with thearticles of incorporation, the directors and shareholders usuallyadopt corporate bylaws that govern the powers and authority of thedirectors, officers, and shareholders.
Even small, private, professional corporations, such as a legalor dental practice, need to adhere to the principles that govern acorporation. For instance, upon incorporation, common stock needsto be distributed to the shareholders and a board of directorselected. If there is only one person forming the corporation, thatperson is the sole shareholder of stock in the corporation and canelect himself or herself to the board of directors as well as anyother individuals that person deems appropriate.
Corporations, if properly formed, capitalized and operated(including appropriate annual meetings of shareholders anddirectors), limit the liability of their shareholders. Even if thecorporation is not successful or is held liable for damages in alawsuit, the most a shareholder can lose is his or her investmentin the stock. The shareholder’s personal assets are not on the linefor corporate liabilities.
Corporations file Form 1120 with the IRS and pay their owntaxes. Salaries paid to shareholders who are employees of thecorporation are deductible. But dividends paid to shareholders arenot deductible and therefore do not reduce the corporation’s taxliability. A corporation must end its tax year on December 31 if itderives its income primarily from personal services (such as dentalcare, legal counseling and business consulting) provided by itsshareholders.
If the corporation is small, the shareholders should prepare andsign a shareholders buy-sell agreement. This contract provides thatif a shareholder dies or wants to sell his or her stock, it mustfirst be offered to the surviving shareholders. It also may providefor a method to determine the fair price that should be paid forthose shares. Such agreements are usually funded with lifeinsurance to purchase the stock of deceased shareholders.
If a corporation is large and sells its shares to manyindividuals, it may have to register with the Securities andExchange Commission (SEC) or state regulatory bodies. More commonis the corporation with only a few shareholders, which can issueits shares without any such registration under private offeringexemptions. For a small corporation, responsibilities of theshareholders can be defined in the corporate minutes, and ashareholder who wants to leave can be accommodated without manylegal hassles. Also, until your small corporation has operatedsuccessfully for many years, you will most likely still have toaccept personal liability for any loans made by banks or otherlenders to your corporation.
While some people feel that a corporation enhances the image ofa small business, one disadvantage is the potential doubletaxation: The corporation must pay taxes on its net income, andshareholders must also pay taxes on any dividends received from thecorporation.
Business owners often increase their own salaries to reduce orwipe out corporate profits and thereby lower the possibility ofhaving those profits taxed twice–once to the corporation and againto the shareholders upon receipt of dividends from thecorporation.
A Subchapter S corporate structure makes sense for many closelyheld businesses. Instead of profits being taxed twice as they arewith regular C corporations (once at the corporate level and againas dividends when they’re distributed to shareholders), profitsflow through the S corporations and are taxed once, at the personaltax rate. Subchapter S corporations offer advantages to newbusiness owners with income from other sources, which can be offsetby business deductions to reduce the individual’s overall federaltax liability. Take note, however, that some states don’t recognizea Subchapter S election for state tax purposes and will taxSubchapter S earnings at the regular corporate rate.
To qualify under Subchapter S, the corporation must:
- Be incorporated within the United States;
- Not be part of an affiliated group that can file a consolidatedtax return;
- Have fewer than 75 shareholders;
- Have shareholders who are individuals, estates, or certaintypes of trusts; and
- Have only one class of outstanding stock.
For more information on the rules that apply to a Subchapter Scorporation, talk with your CPA.
